Eurozone Financial System Seizing Up

Money is to the economy what blood is to the human body. So long as both are circulating smoothly, they’re doing fine. But when liquidity starts to choke in the veins of the economy, as is happening now, it points to a coming seizure.

The European Central Bank admitted it had held meetings about providing emergency funding to the region’s struggling banks, however City figures said a “collateral crunch” was looming.

“If anyone thinks things are getting better then they simply don’t understand how severe the problems are. I think a major bank could fail within weeks,” said one London-based executive at a major global bank.

The early warning signs of such a liquidity seizure are already showing up in the troubles that European banks face in raising short-term liquidity. French, Italian and Spanish banks have run out of collateral (typically US Treasures) that they put up to finance short-term loans, and have been forced to pledge their gold reserves in order to secure dollar funding, reports The Telegraph.

The fear is the European authorities do not have the financial firepower to deal with the banks’ problems. Analysts at BarCap say that even if the European rescue funds were able to raise €1 trillion of funding this would only meet the needs of the Italian and Spanish government and banks.

The European banking sector’s problems are being exacerbated by a wave of asset sales as lenders look to dramatically shrink their balance sheets. UBS estimates eurozone banks could sell off between €3.7 trillion and €4.5 trillion of assets in the next three years.

David Lyon of Barclays Capital, an investment bank, reckons that just €17 billion ($24 billion) in unsecured European bank bonds have been sold since the end of June, compared with €120 billion in the same period a year earlier. “In the context of the requirement, this is a paltry amount of funding,” he says.

Now, governments are leaning on banks to keep buying their bonds. As a result even the strongest banks from peripheral euro-area countries such as Spain or Italy (where yields on an auction of three-year government bonds surged to an unsustainable 7.9% on November 29th) are finding it hard to borrow from investors.

Yet the bond-buyers’ strike afflicting banks is more worrying than the sovereign one. No banks are regarded as havens in the way that British and German government bonds provide a refuge for investors. Even strong banks in “core” euro-area countries are being frozen out of markets.

A second vital source of funding is borrowing through short-term interbank markets or tapping money markets. Both of these are also drying up. American money-market funds, which were a big source of dollars for the European banking system, have reduced loans by more than 40% over the past six months.

Banks are reluctant to lend to one another except for the shortest possible time, usually overnight. “Every night for the past few months [chief financial officers of big banks] have been getting reports saying they are short of a few billion,” says one banker. “They take the phones and start calling all the other banks to ask if they can borrow €100m here and some there.”

For now, this is keeping the system ticking over, partly because a bank lending money overnight knows it may have to ask for the favour to be returned next week. Euro-area central banks are also leaning heavily on their biggest banks to keep supporting the smallest with interbank loans.

Banks are responding by desperately hoarding the cash they have, selling assets and slowing new lending.

The longer banks are unable to raise funding, the greater the chance that one may fail. As one banker ominously puts it: “you are getting further along the train tracks towards the buffers.”